A 'Templeton Trade' on China

Sir John Marks Templeton, who lived from 1912 to 2008, was a well-known investor, but he may not get the credit he deserves. Without question, Templeton belongs to that small club of greatest investors of all time. What set him apart was his willingness to buy out-of-favor assets that were shunned by the majority. He pioneered the use of mutual funds in the global investment arena, and in the 1960s he invested in Japan and other countries and came out a billionaire.

Templeton may be most famous for a bold bet he made in 1939, when war in Europe led to a plunge into equity prices. Templeton purchased $100 of every stock that traded below $1 a share on both the New York Stock Exchange and American Stock Exchange. That bet led Templeton to invest $10,400 (about $166,400 in today's dollars) in 104 companies. One-third of those companies were bankrupt at the time of investment. In 1943, Templeton sold the basket of stocks for over $40,000, nearly quadrupling his money in four years.

Fast-forward to today, and you have a whole bunch of Chinese small-caps that are ripe for a Templeton-type trade. Most of these names are products of reverse mergers and have been subject to intense scrutiny over the years regarding their legitimacy. While more than a few of these companies are likely to be complete flops, some will turn out to be home runs.

For a lot of reasons, a reverse merger for a Chinese company makes sense: It's a cheaper and quicker way to take a business public. Unfortunately, that appeal does create some unscrupulous activity. And when a sophisticated investor such as John Pauslon can lose his shirt on Sino-Forest, it goes to show that even the utmost of due diligence can prove ineffective.

Templeton's approach may be the best angle to exploit this trade. Otherwise, it's too tempting to look at a name such as China Green Agriculture (CGA) and not want to make a decent size bet. China Green trades for $4.46, for a $120 million market cap. The company sits on $60 million in net cash, or more than $2 per share. Net margins are near 20%, book value per share is $7.61, and if that weren't enough, the shares trade for 3x earnings.

But similar eye-grabbing valuations are to be found with SORL Auto Parts (SORL), Lihua International (LIWA), American Oriental Bioengineering (AOB) and Zhongpin (HOGS), to name just a few. These businesses are involved in auto parts, medicine and meat production. The fear of a Chinese economic slowdown along with a legitimate concern as to the validity of Chinese small-caps has tarnished them all. Quite simply, investors have no reason to trust the financial statements they are seeing.

But China is real, and its long-term growth is a given. As a result, some of these smaller names trading in the U.S. are going to be grand slams while others will be complete frauds. Given the potential for extraordinary gains amid the potential losses, a "Templeton trade" is something to consider at this juncture.

In the upcoming weeks, I will create a mock "Templeton 1939 Mock China Portfolio" and chart its progress throughout the year for Real Money readers.

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Please note that due to factors including low market capitalization and/or insufficient public float, we consider CGA, SORL, LIWA, AOB and HOGS to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices